European Commission Consultation Paper: towards UCITS VI

On 26 July 2012, the European Commission (the “Commission”) published a consultation paper entitled Product Rules, Liquidity Management, Depositary, Money Market Funds, Long-term Investments (the “Consultation Paper”), available here. It explores various topics with a view to amending the UCITS Directive and calls for industry feedback.

This consultation process will shape any further amendment to the UCITS regime and will form the basis of “UCITS VI” to build on and amend the recently introduced UCITS IV and the upcoming UCITS V.

The Consultation Paper focuses on eight topics of concern to the Commission and is framed in the form of very broad questions posed to industry.

This update does not propose to consider the Consultation Paper in full but is a brief summary of the main points:

Topic 1: Eligible assets

The Commission evaluates the current practice in relation to the instruments currently permitted to be held by a UCITS but expresses a concern that the emerging practice of a UCITS adopting highly sophisticated investment strategies that provide access to highly complex risk profiles may not be appropriate for a retail fund.

The Commission then poses a list of eight broad questions to stimulate feedback. For example, it queries whether there is a need to review the scope of assets and exposures deemed eligible for a UCITS and whether all investment strategies currently observed in the marketplace are in line with what investors expect of a regulated UCITS product.

Topic 2: Efficient portfolio management techniques

The Commission summarises the types of techniques and instruments employed by UCITS for the purpose of efficient portfolio management (“EPM”) but raises some concerns that there may be some systemic risk inherent in the use of some EPM techniques. The Commission notes several questions have been raised regarding: (i) the transparency of EPM techniques; (ii) counterparty risk assumed by those funds using EPM; and (iii) the quality of collateral or the reinvestment of collateral. The Commission then poses a number of questions and requests feedback from industry including what type of transactions and instruments should be considered as EPM techniques and whether there is a specific need to further address issues or risks related to the use of EPM techniques.

Topic 3: OTC derivatives

The Commission raises queries in relation to the treatment of over-the-counter (“OTC”) derivatives cleared through central counterparties particularly in the context of counterparty exposure and questions whether an assessment of the current framework regarding operational risk and conflicts of interest is required. The Commission also queries what the current market practice is in relation to the frequency of calculation of counterparty risk exposure and whether there would be any benefit in calculating this on a daily basis.

Topic 4: Extraordinary liquidity management rules

The Commission summarises the current liquidity issues faced by some UCITS and explores the perceived “liquidity bottlenecks” faced by some UCITS. The Commission notes that whilst the UCITS Directive provides that a UCITS shall redeem units on request by investors, it does not specify how, in practice, such a right must be applied. For example, it does not set time limits for the execution of redemption orders.

The Commission notes that during the financial crisis some UCITS were confronted with liquidity bottlenecks such that they were unable to redeem units on request and queries whether more developed rules on a European wide basis may help fund managers facing liquidity bottlenecks and ensure higher levels of investor protection to better support the functioning of the single market.

The Commission also draws attention to secondary markets for exchange traded funds (“ETFs”) and notes that specific measures may be necessary to guarantee liquidity for ETF investors.

Topic 5: Depositary passport

The Commission notes that, at present, UCITS depositaries have no European passport due to the fact that the UCITS Directive requires that a depositary shall either have its registered office or be established in the UCITS' home Member State. The Commission further notes that the fund industry has been debating whether UCITS should be limited to the services of depositaries located in the same jurisdiction as the fund.

The Commission states that the AIFM Directive and the UCITS V proposals aim to harmonise the rules governing entities eligible to act as depositaries, the definition of safekeeping duties and oversight functions, the depositary's liability, and the conditions for delegation of the custody function. The Commission requests feedback on the advantages and drawbacks of such a passport being allowed.

Topic 6: Money market funds

The Commission raises concerns that money market funds (“MMFs”) may represent a source of systemic risk (i.e. ‘runs’ by investors or contagion etc).

The Commission deals with MMFs under three separate sub-topics: (i) valuation and capital; (ii) liquidity and redemptions; and (iii) investment criteria and rating.

Under valuation and capital, the Commission raises a concern over constant net asset value MMFs. The Commission notes that constant net asset value MMFs may give the impression to investors that they contain a capital guarantee. The Commission is also concerned that the amortised cost valuation method (used by constant net asset value MMFs) allows the MMF to disregard the gap between the real value and the book value of assets. The Commission queries whether these types of MMFs require additional regulation of whether they should be phased out entirely.

Under liquidity and redemptions, the Commission notes that MMFs allow investors to withdraw on demand, with almost immediate execution and a relatively stable principal value. However, these MMFs also invest in assets that mature in the future and which do not necessarily display daily liquidity. The Commission is concerned that this situation might impede the MMF's ability to face large redemption requests from investors. The Commission requests feedback as to possible solutions to prevent liquidity bottlenecks or whether additional liquidity constraints would be useful.

Under investment criteria and rating, the Commission notes that the MMF industry relies extensively on credit ratings in order to assess credit risk associated with their assets. The Commission states that such a sharp decline in the fund's assets might have systemic effects given the presence of a rating. The Commission is seeking opinions on whether it remains appropriate for MMFs to be rated or if this should be prohibited.

Topic 7: Long term investments

The Commission raises the issue of long-term investments in a UCITS context (i.e. investments including direct investments into unlisted companies, infrastructure projects, real estate, and third-party managed funds making investments in unlisted companies). The Commission notes that long-term investments are generally associated with long lock-up periods and access to these types of investments is normally reserved for institutional investors only. The Commission notes however that some EU Member States have sought to develop ways of facilitating access to long-term investments for retail investors but no common approach has emerged.

Recognising the benefits for economic growth in promoting long-term investment, the Commission wishes to consider whether retail investors or fund managers consider that there may be a market for a pan-EU long-term retail investment product. The Commission calls for feedback on allowing retail investors invest in these types of assets – perhaps within the UCITS framework (proportionate allocation) or as part of a stand along product initiative.

Topic 8: UCITS IV updates

In recognising some of the measures introduced under UCITS IV are not operating as envisaged, the Commission raises some specific areas where further enhancement may be appropriate. These include: (i) prescribing more detailed organisational rules for self-managed companies; (ii) certain changes to the mechanics for operating master feeder structures; (iii) certain changes to the mechanics for operating fund mergers; and (iv) certain improvements to the cross-border notification procedures.

The Commission also notes that in relation to the AIFM Directive some of the measures on organisational rules, delegation, risk and liquidity management rules, valuation, reporting or calculation of leverage are more detailed than in the UCITS Directive. The Commission queries whether further harmonisation between the AIFM Directive and the UCITS Directive is required.

What happens next?

This consultation marks the start of a process for UCITS regime changes that will take up to two years (and maybe longer) to come into effect. It is fair to say there is a degree of dismay in the industry about further changes to the UCITS regulation being proposed by the Commission before the UCITS V Directive has even been finalised. However, a welcome aspect of this initiative is that the Commission have framed this first phase of UCITS VI in the form of an industry consultation and have asked questions as to how the current model may be enhanced. As such, it is expected that industry participation and input will be critical in driving the agenda on this. As well as inevitably meaning increased regulation, the outcome could actually produce positive results that benefit the industry and investors.

The Commission has invited contributions by 18 October 2012 and these can be sent to: Markt-Ucits-Consultations@ec.europa.eu. Alternatively, please feel free to pass on any comments or contributions you may have to any of the individuals listed above or to your usual Maples contact so that your contribution can be added to a wider industry response.